How a tax on wealth became a tax on the middle class

Over the last 20 years, the state’s interest and dividends has been transformed into something its creators would not recognize

New Hampshire’s interest and dividends tax has strayed very far from its roots as a tax on the rich.

The tax was created in 1923, at the end of the Progressive Era. In the 19th century, most taxes were property taxes. After the Civil War, as the industrial revolution transformed the economy, it became clear that an increasing amount of economic activity — dividends, capital gains, CEO bonuses, etc. — was never taxed, leaving property owners to carry the load alone.

The solution at the federal level was the income tax. New Hampshire took a different route, adopting a tax on interest and dividends. It was designed to be a tax on the wealthy. Most working-class people had little or no interest and dividend income. In addition, interest earned on accounts in New Hampshire banks were exempt, which had the dual purpose of excluding the small saver from tax, and also encouraging the retention of capital in New Hampshire.

Over the last 20 years, the Legislature has transformed the interest and dividends tax into something its creators would not recognize.

First, there was a constitutional challenge brought by wealthy taxpayers in the 1990s, arguing that the tax violated the “commerce clause” of the U.S. Constitution, because the exemption for interest paid by New Hampshire banks gave those banks an unfair advantage. The state eventually conceded that the exemption was unconstitutional, and the Legislature eliminated the exemption in 1995. Savers who had deposited their savings in New Hampshire banks were suddenly subject to New Hampshire income tax.

Second, the standard exemption from tax has remained unchanged at $2,400 since 1997. If the exemption amount had kept pace with inflation, it would be over $3,500 today.

Third, dividends paid by corporations are taxed, but dividends paid by most limited liability companies (those with non-transferable shares) are exempt from tax. This is a huge loophole, which gets bigger every year.

Over the past five years, hundreds of New Hampshire corporations have converted to LLC status, transforming their dividends from taxable to non-taxable.

Remember when Walgreens planned a “corporate inversion,” to avoid paying U.S. tax? We have our own tax-avoiding “inversions” here in New Hampshire. Change the name from “Inc.” to “LLC” and you have spun taxable income into non-taxable income.

Fourth, the Legislature recently exempted all trusts from interest and dividends tax. This means a trust can accumulate interest and dividend income free of any New Hampshire tax.

Not surprisingly, there is a cottage industry among New Hampshire lawyers to create trusts for wealthy clients. Stock and bond portfolios are transferred into these new trusts, and the interest and dividends earned on those portfolios are not subject to interest and dividends tax so long as the income is accumulated. When the accumulations are paid out, only the income of the most recent year is taxable — the accumulated income from previous years can be distributed tax-free.

Over the past 20 years, average people have seen their New Hampshire bank interest subject to tax, and they have seen the value of their exemption eroded by inflation. The result is that some retirees pay interest and dividends tax on the money they saved for retirement, even though their income is too low to owe any federal income tax.

Meanwhile, lobbyists for the wealthy have worked their magic. Their clients are busy converting their corporations into limited liability companies, and transferring their portfolios into trusts, all to avoid the interest and dividends tax. We are now seeing the results. Interest and dividends tax revenue for the 2014 fiscal year was 17 percent below projections.

We are told that the state must “live within its means.” What we aren’t told is that the “means” of the state are being whittled away by lobbyists, as they carve out tax benefits for their clients.

Mark Fernald of Sharon is a former state senator, and was the 2002 Democratic nominee for governor.